I’ve heard numerous pundits and investment talking heads issue the same dire warning: “Stock buybacks are artificially propping up the market and this will end badly”. In fact, this is the second most popular artificial stock market propper-upper next to the Federal Reserve (I’ve defended the Fed here and will have more to come on that soon). So, as is my nature, I feel the need to dispel this fear-mongering. It turns out that stock buybacks are not some phony financial manipulation. Despite arguments to the contrary, they are not artificial at all, but rather are a natural, even healthy, part of capitalism.
What are Stock Buybacks?
Stock buybacks are simply when a corporation buys shares of its own stock in order to reduce the overall shares outstanding. Imagine that you own 5 shares of a company which has 100 shares outstanding. You would be 5% owner of this company. Now if the company buys back 10 shares – you still own your 5, but now you own 5 out of 90 or 5.56% of the company. If the company still makes the same amount of money, (say $1000) that means you have a claim to a larger share of those earnings ($55.60 instead of $50).
Why Would Buybacks “Prop-up” the Market?
According to the Investment Company Institute (ici.org) flows out of U.S. stock mutual funds and ETF’s over the last 12 months as of August 31st, reached over $84 billion. That means that investors have pulled money out of U.S. stocks. With that level of capital coming out of the stock market, how is it still going up? As of September 30th, the S&P 500 was up 7.84% year-to-date. With so much selling, where is the buying? The answer to that question is that over the first three months of year, U.S. corporations bought back over $160 billion shares of their own stock – more than making up for the selling going on via mutual funds and ETF’s.
Back in March, an article in Bloomberg titled “There’s only one Buyer of Stocks” (link here) stated that “rampant selling” of stock mutual funds and ETF’s by investors was being offset by an amount of corporate buybacks “approaching a record not reached since 2007”. The chart below from the article shows how fund flows have been negative while buybacks have increased. And of course, all you have to do is compare any data point to 2007 (or 2000 or 1929) for alarm bells to start going off and pundits to start losing their minds.
The argument goes that companies are spending all this cash to buy back their own stock because they do not have any growth opportunities and do not want to reinvest in their business. They are trying to mask poor business results by making things look better and growing earnings-per-share (EPS) by lowering the denominator (shares outstanding) instead of increasing the numerator (earnings).
An article from thestreet.com (link here) states “Stock Buybacks are reaching peak levels” and then asks “Is a market crash around the corner?”
An article from the NY Times (link here) makes an argument that buybacks are not only artificially propping up the market, but they are bad for companies. They quote a professor of economics from the University of Massachusetts as saying “Executives who get into [the stock buyback] mode of thinking no longer have the ability to even think about how to invest in their companies for the long term. Companies that grow to be big and productive can be more productive, but they have to be reinvesting”
Unfortunately, the framers of these arguments miss some very important lessons about economics and finance.
Stock Buybacks Are a Legitimate Source of Buying
To say that corporate buybacks don’t count as real demand or to call it artificial does not make any sense. Demand is demand, whether it comes from retail investors, institutions, or the corporations themselves. Going back to the Bloomberg article mentioned earlier, a director of equity research was quoted as saying “Anytime when you’re relying solely on one thing to happen to keep the market going is a dangerous situation”. This suggests that if corporations stop buying stock, the market could crash. Well I suppose that is possible, but what if individual and institutional investors decide they are tired of missing out on this rally that won’t end and dollars come flooding back into stock funds? The opposite could happen.
As it turns out, while the first quarter of 2016 saw a big increase in buybacks, the second quarter saw a big decline to a level last seen in 2013. Despite this drop in the level of corporate buying the market was up 2.5% during the same time period. So the correlation between buyback level and stock market performance is weak because other forms of capital can come into the market at any time.
Stock Buybacks are a Tax-Efficient Benefit for Investors
Imagine you own 5% of a company like the example above. This company can either pay you a $10 dividend, or it can use that money to buyback shares. Well the dividend would be taxable income right at the time it is delivered. It is taxable at a favorable dividend rate and dividends are not bad to get, however, the buyback is not a taxable event. You are only taxed when you sell the appreciated shares which gives you greater flexibility from a tax perspective.
Stock Buybacks Lower a Company’s Cost of Capital
People who argue that stock buybacks deliver a one-time benefit by simply lowering the shares outstanding and making EPS look better must have forgotten their Corporate Finance classes in college. I teach corporate finance and one of the important lessons we discuss is about capital structure and the cost of capital. The analogy I use to describe the capital structure of a company is if you have $100,000 house with an $80,000 mortgage, that means you have 20% equity and 80% debt.
Each form of financing (equity and debt or stocks and bonds from the investors perspective) has a cost associated with it. For bonds, that cost is easy to determine. It is simply the amount of interest you need to pay your creditors. In the example above, if your mortgage is 5%, than your cost of debt financing is 5%. Determining the cost of equity financing, however, is harder because it’s the return expected by investors in the company’s stock. This figure is never explicitly given in real-life but due to it’s riskier nature, the cost of equity financing is most often higher (sometimes substantially so) than debt financing.
In today’s world of super low interest rates, why would a rational company not borrow cheap money to retire a more expensive form of financing? Take the example of Apple. Last year it borrowed $1.35 billion of swiss-franc denominated debt at a yield of 0.74%. Can you imagine borrowing money at less than 1%!? They can instantly turn-around and use this cheap money to buyback stock and lower their overall cost of capital. Anyone who says this move is short-sighted and that they would be better served making an acquisition or pumping that cash into research and development are clueless. Not only is this move a benefit to shareholders as their ownership stakes increase, but Apple has made all future investment projects (either R&D centered or acquisition) more valuable by lowering the discount rate applied to the expected cash-flows from those projects!
Corporations are smart to borrow super cheap money to buy back their own stock as long as they keep overall debt levels reasonable. It’s not financial engineering or hocus-pocus, it’s just Corporate Finance 101. As the cost of capital decreases for these companies, it will make future projects more profitable, and hence making our economic future more promising, not less so.
So, the next time some yahoo on television or the radio starts sprouting off about the artificial bubble in markets created by stock buybacks, you do not need to panic. Stock buybacks are just a part of capitalism and like everything else in this world, it ebbs and flows in cycles. The market was not saved by buybacks, rather the market offered the opportunity for these buybacks and if you’re an investor in the stock of company that is buying back stock, just remember that you own a larger piece of the business after the buyback than before. That’s not a terrible position to be in.
Until next time….
“The first law of capital allocation—whether the money is slated for acquisitions or share repurchases—is that what is smart at one price is dumb at another.” – Warren Buffett